The Hindu Business Line : Securitisation: Potential and pitfalls

The concept is simple. Apart from investments, assets of a bank are mostly loans given to corporates, small businesses and individuals. The major difference between investment assets and loan assets is that the former are tradeable (and transferable) while the latter are not. In other words, investments have the advantage of liquidity, i.e., they can be quickly converted into cash. And adequate liquidity is one of the hallmarks of a healthy bank and its balance sheet.

The problem was how to make the loan portfolio of a bank liquid. Someone got the clever idea of transforming loans into securities, so that they are imparted and acquire the characteristic of marketability - having buyers for loans turned into securities. The process naturally came to be called securitisation.

It has become big business in the US. Starting with housing mortgages, this financial technique has spread to all kinds and types of asset classes - credit card receivables, auto loans, even bundling existing securities into new securities, called collateralised debt obligations.

Securitisation is fast catching up in India. Indeed, the more canny of the new-generation banks see it as the essence of modern banking, whose functions can be clearly delineated into origination of asset portfolios and their subsequent divestment. Divestment is made possible through securitisation.

Clearly, it is a boon in these times of demanding capital adequacy and provisioning standards required on the part of banks. The balance of a bank is viewed as a dynamic in which churning and turnover become critical to maximising business and profits within given capital and risk limits. In fact, the Basel II norms necessitate precisely this approach to profitability, risk and balance sheet management.

The credit rating agencies have a critical role to play in securitisation, as they are responsible for rating the securitised assets. On them depends the quality of these investments and therefore the health of the investing institutions' balance sheets.

Here it is worth mentioning that the RBI has taken several welcome steps to ensure that minimum appraisal and credit standards are evolved and applied to banks' investments in non-SLR bonds. It is necessary for the central bank to examine and assess securitisation in terms of the due diligence done by the securitisers and most important, the credit rating agencies.

There is a need for full disclosure and transparency, legal covenants and investor protection, whether investors are institutions or individuals. The enormous advantages of this sophisticated piece of financial engineering in managing banks' capital and risks should be captured without increasing systemic risk.

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Securitisation: Potential and pitfalls